HOW THE DEAL FOR RUE21 COULD FALL APART
c.2013 New York Times News Service
The fashion retailer rue21 is about to find out how much reputation in private equity deals still matters.
In 2007 and 2008, the general rule was that if a private equity deal no longer made economic sense, it would fall apart, no matter how strong the contract or the risk to reputation.
We saw this time and again in buyouts involving Huntsman, Penn National Gaming, Clear Channel and other private equity deals which either failed or, if the targets were lucky, were renegotiated when the bidding private equity firm tried to walk away.
It is now rue21’s turn to see whether things have changed since the financial crisis. Rue21 agreed in May to be acquired by Apax Partners in a $1.1 billion deal. Last month, rue21 said that it had weak sales in August, typically a strong back-to-school period. Same store sales were down 7.6 percent from a comparable period a year earlier, the company said.
Apax is financing this deal by putting in up to $283 million of its own money and borrowing up to $780 million. This deal will only work if it can borrow hundreds of millions of dollars.
But the sales decline has spooked the debt market. The three banks on the deal — JPMorgan Chase, Bank of America and Goldman Sachs — are now trying to sell the $780 million in debt, but there are reports that potential buyers are only willing to pay around 80 to 85 cents on the dollar. This would leave the banks with a total loss of perhaps more than $150 million, with JPMorgan losing 45 percent of the total, Bank of America another 45 percent and Goldman 10 percent.
The reverse termination fee, which Apax would have to pay if the deal failed because of financing was unavailable, is only $62.718 million. The economic incentive here, absent the parties’ contractual and moral obligations, is to walk away from the deal (or for the banks to just pay that amount to rue21, halving their loss).
The question is what happens next.
We’ve seen this dance before, primarily in the $27.5 billion Clear Channel deal. In that 2008 transaction, the banks ended up being the ones that served as a catalyst for renegotiating the deal after the debt financing became uneconomical. The banks and the private equity firms buying Clear Channel sued each other to get out of the banks’ commitment to finance the debt, leading to a renegotiation of the transaction.
As in the Clear Channel deal, the banks have the biggest incentive to try to walk away, but Apax itself may also be wondering if this deal still makes sense.
Let’s start with Apax’s ability to exit the deal.
The acquisition agreement is pretty much state of the art and reflects some of the target friendly provisions added in the wake of the financial crisis. Apax is required to use its reasonable best efforts to obtain financing for the transaction. This specifically includes a requirement that Apax, if necessary, pursue, in good faith, litigation against the banks to force the banks to finance the debt. If the financing cannot be obtained after litigation and any other efforts, Apax is required to pay that $62.718 million termination fee. But otherwise, that is its only obligation.
So Apax may have some defenses, including arguing that specific performance is unavailable, as was done in the Dow Chemical/Rohm & Haas deal. But that is probably a losing argument. (Specific performance, by the way, is a legal term meaning that a party can force the other party to do what is required under the contract instead of paying financial damages.) In the rue21 deal, the argument would be that specific performance typically requires that financial damages be unavailable, and so cannot be given. That would leave Apax liable for only the reverse termination fee instead of the larger loss for completing the deal. Apax’s problem with this claim is that it said in the acquisition agreement that specific performance could be granted by a court, making it a likely loser.
Nor is a material adverse change claim likely to get far. If rue21 experiences a material adverse change, Apax can walk away without paying a dime. But the problem is that a material adverse claim is hard to establish under Delaware law, which governs the acquisition agreement. Such a claim must show that the material adverse change — that is, damage to the company — is long term in effect as well as unexpected. Moreover, the way the clause is defined in the acquisition agreement, the material adverse claim would have to be counted against any adverse effects to rue21 over and above the rest of the industry. Apax can raise this claim as a litigation strategy, but this is a high standard and unlikely to be a winner. In fact, the Delaware courts have never found that a material adverse claim was established.
So with Apax locked in, that leaves the banks. The banks’ obligations will be guided by the debt commitment letter in which they promised Apax to finance this debt. Any litigation brought by the bank will be in New York under the terms of the debt commitment letter.
The banks also have a material adverse claim clause in the debt commitment letter that allows them to exit the transaction if Apax establishes a material adverse claim. But since this clause mirrors the one in the main agreement between Apax and rue21, the banks are unlikely to get far with such a claim.
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But the banks have at least two other outs.
The first and best option is to argue that rue21 is insolvent. To be required to finance the debt, the banks need a certificate from rue21’s chief financial officer attesting that rue21 is solvent. This issue came up in the $41 billion BCE private equity buyout that fell apart because a solvency opinion could not be obtained.
In this case, the form of the solvency certificate is appended to the debt commitment letter. It requires rue21’s chief financial officer to certify three things: first, that the value at which the company or its assets can be sold in an independent transaction exceeds the actual and contingent liabilities of rue21; second, after the transaction, rue21 has enough capital to function; and third, rue21 can pay its debts after the transaction.
It may be that rue21 can service this debt, but the issue here is going to be the first certification — the test of whether rue21’s debt after the transaction exceeds the fair value of rue21. And while the chief financial officer, Keith A. McDonough, is the one giving this certificate, he will rely on rue21’s auditor, Ernst & Young, in giving it. But Ernst & Young may balk, as the accountants did in BCE. And even if the certificate is provided, the banks can litigate its veracity.
The second grounds for the banks to defeat this deal is a complicated one, but comes up in the context again of specific performance. Essentially, the banks can argue, as they did in Clear Channel, that they can’t be forced to finance this debt. While this would leave them with a possible monetary damages claim with Apax, given that these parties deal with each other all the time, that can be worked out. In any event, the financial damages would be the $62 million reverse termination fee. This is a tough claim to make in New York but totally untested. So it is probably worthwhile for the banks to pursue.
What this means is that there is enough here for the banks to fight in litigation to kill this deal. Any litigation against the banks would have to be brought by Apax which itself might not want to fight too hard. While rue21 can join in, perhaps with a claim of interference of contract, it must also sue in New York, given that the contract requires that rue21 litigate any matter against the banks on this transaction in that state. This is not as big a threat as perhaps suing in Pennsylvania, rue21’s home jurisdiction.
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Ultimately, the banks, and perhaps Apax, have enough to make a claim. This is true despite all the new features put in private equity deals since the financial crisis. The question is whether the banks or Apax want to risk their reputations for $100 million or more. During the financial crisis, reputation didn’t go far. But perhaps things have changed.